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Change, to be sure, is occurring. And more is inevitable, if the Financial Accounting Standards Board finally succeeds in requiring the expensing of at least some employee stock options, as a rule it has proposed would do beginning in 2005. Although they agree on little else, advocates and opponents of expensing do agree on one thing: if companies have to expense options, most will use fewer of them. In fact, companies have already curtailed their use of options, partly because boards are anticipating the new rule and partly because the recent stock-market slump made options far less attractive to managers.

Expensing should also prompt companies to look seriously at ways to link long-term incentives to performance goals. Companies currently have to expense performance shares, since the exemption applies only to options whose exercise price and quantity are fixed on the grant date. Require the expensing of all compensation, though, and boards will no longer have an accounting reason to dismiss options with a performance component. Expecting that the expensing rule will take effect next year, a number of companies have already started using performance-based options.

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A survey by CFO magazine of 131 companies suggests that these changes will accelerate if FASB gets its way. This is good news for those who think that options contributed to the excesses of the 1990s. But there are reasons to doubt that expensing of options will magically produce better alignment between executive pay and shareholder wealth. That is because the basic governance problems that allowed compensation committees to dole out questionable incentives to managers still exist. Unless boards show true independence, there’s a good chance that top managers will continue to receive pay that isn’t tightly hitched to performance, and that shareholders will once again be left paying the consequences.

The Trouble with Options

When stock options first took off in the early 1990s, many investors greeted them as the answer to a long-standing problem: how to make managers act like owners without rewarding them even if they botched the job. Compensation committees embraced options for another reason: granting them incurred no charge to earnings.

But fixed-price options created perverse incentives. Because there are no restrictions on when an executive can unload options upon vesting, they invite steps to fuel a short-term rise in stock price, even if the decision doesn’t make long-term sense. CFO found that 23 percent of finance executives at public companies think stock options have led to such actions at their companies.

A number of academic studies have established a link between options and earnings manipulation. One new paper, by Jap Efendi, Anup Srivastava, and Edward P. Swanson of Texas A&M University, shows that the likelihood of an accounting restatement is higher at companies where CEOs have large holdings of in-the-money options. The study also found that these CEOs realized more cash from their options in the two years preceding a restatement than did their counterparts in other firms.

Options are also inefficient. Research shows that employees value options at a small fraction of their Black-Scholes value, because of the possibility that they will vest underwater. “You might have to give managers a lot of options to make them feel as well off as they would if they were paid in cash or stock,” says Jesse M. Fried, a professor of law at the University of California, Berkeley. “From the board’s perspective, these options might seem free, but you’re actually taking a lot of money out of shareholders’ pockets to pay employees.”

Change Is Coming

By taking some of the luster off options, the expensing rule will help alleviate these problems. Our survey shows that under expensing, companies would continue to move away from options and increase their use of virtually all other forms of compensation.

For example, while the proportion of companies granting options would drop from 87 percent to 71 percent, the percentage using performance-vesting equity would rise from 35 percent to 47 percent, and the proportion using restricted stock would go from 66 percent to 75 percent. Companies also expect to use more stock-option substitutes, such as stock appreciation rights (SARs) and phantom stock. One reason: both pay executives for stock-price appreciation without causing as much dilution. If an employee has 100 options and the share price rises from $5 to $10, he’ll make $500. With an SAR or a phantom stock, the company would just settle that spread by giving the employee 50 shares of stock — 50 fewer than would be needed with options.

Performance shares have long been a favorite of shareholder activists. More often discussed than actually used, this is a type of equity that vests only when the company has achieved certain goals. While companies are generally secretive about their long-term hurdles, our survey shows that internal measures of financial performance — including profits, revenue, and return on capital employed — are the most common. Others require that the company’s share price outperform some benchmark, such as a peer-group index or the S&P 500.

Level 3 Communications Inc., a $4 billion fiber-optic network operator, is one of the few longtime users of performance-based options. According to CFO Sunit Patel, the company’s program, which he helped design, grew out of a desire to create a shareholder-friendly option program. “Our feeling was that while regular stock options are good, they can amount to essentially offering employees a free ride,” he says. The solution was to create an option that would have value only if the company outperformed the S&P 500. Because payout is less likely with this plan, Level 3 applies a sliding multiplier to any performance better than the index. The options rapidly become more valuable as the share price outperforms the S&P 500.

Performance options aren’t a panacea, though. One problem is that if the requirements are too rigorous, they may not be much of a motivator. “At the end of the day, if your options are very rigid from a value standpoint, people will look at it and say, ‘I’ll never get this,'” says John Moyer, a partner with Ernst & Young’s human-capital practice. “You run the risk of having an incentive plan that’s not an incentive plan.” And since, like regular stock options, performance shares reward only an increase in the stock price, they do a lousy job of retaining employees when the options are underwater.

One way to address the problem is by moving to a broader portfolio of compensation tools. “You need a portfolio, because generally the same incentives can’t be both retentive and performance-based,” says Ira Kay, an executive-compensation consultant with Watson Wyatt in New York. He recommends that companies consider plans that include restricted stock (for retention), as well as some regular stock options and performance-vesting shares (for motivation). Our survey shows that many companies will take this approach: stock options won’t disappear from compensation plans, but they will become less important relative to other kinds of compensation.

Expensing of options will have one other effect: as opponents of the new rule have argued, it will cause many companies to dump their broad-based employee stock option plans. Companies expect that during the next two years, the percentage offering options to junior executives will drop from 67 percent today to 34 percent. The percentage granting options to nonmanagerial employees will fall from 27 percent to 10 percent.

Why Expensing Won’t Fix Everything

But there’s a limit to how much these changes will improve matters. That’s because despite recent governance reforms requiring compensation committees to consist of independent directors, executives still wield considerable influence over their pay. As Jesse Fried of Berkeley and Lucian Arye Bebchuk of Harvard argue in a summer 2003 paper, “Executive Compensation as an Agency Problem,” compensation committees are often reluctant to drive a hard bargain with the CEO. That’s because CEOs play too big a role in the renomination of board members, board members are insulated from shareholder wrath, and directors generally have little to lose in salary negotiations, while the CEO has a great deal to gain.

This helps explain the massive option payouts some boards have made for mediocre performance, and could lead to similar abuses with other forms of compensation, such as large grants of restricted stock or performance shares with low hurdles. “It’s very likely that boards will not be as tough with performance requirements as they would if it were their own company and they had hired managers to make value for them,” says Fried.

This could be the explanation for last year’s award of performance shares to Danaher Corp. president and CEO H. Lawrence Culp Jr. The company, a Washington, D.C.-based tool and scientific-instrument maker, granted Culp $35.7 million in restricted stock in 2003, which will vest if he is still CEO by the end of 2009 and if Danaher has four consecutive quarters during which its diluted EPS is at least 10 percent higher than it was for the four quarters ending March 31, 2003. Given that the company’s diluted EPS has risen an average 34 percent annually since 1993, this looks more like pay for attendance than for performance.

Still, those who work with compensation committees report that, on the whole, committee members are far more serious about their jobs today than they were in the 1990s. “The level of scrutiny is much more intense today than a couple of years ago, and as a result there’s a new level of care and detail,” says Claude Johnston, managing director of Pearl Meyer Partners, an executive-compensation consulting firm. “Many directors are truly concerned about reputational risk. They don’t want their names splashed across the papers.”

The real test will come when the market stages a sustained recovery. Shareholder hand-wringing over executive pay can turn to apathy when profits soar. Executives will once again compare their pay packages to those of their peers and demand similar conditions, whether that means larger grants of stock or easier benchmarks.

If companies start implementing some basic governance changes, such as separating the CEO and chairman’s roles or requiring board members to hold a certain amount of company stock, the recent changes could stick. If not, this could be a short-lived revolution.